PRACTICE NUMERICALS ON EBIT- EPS ANALYSIS

1. Vedansh Limited has a share capital of ₹ 10,00,000 divided into shares of ₹ 100 each.
For expansion purpose, the company requires additional funds of ₹ 5,00,000. The
management is considering the following alternatives for raising funds:
Alternative 1: Issue of 5000 Equity shares of ₹100 each
Alternative 2: Issue of 10% Debentures of Rs. 5,00,000
The company’s present Earnings Before Interest and Tax (EBIT) is ₹ 4,00,000 p.a.
Assuming that the rate of Return of Investment remains the same after expansion, which
alternative should be used by the company in order to maximise the returns to the equity
shareholders? The Tax rate is 50%. Show the working.

2. Krish limited is in the business of manufacturing and exporting carpets and other home
décor products. It has a share capital of ₹ 70 lacs at the face value of ₹ 100 each.
Company is considering a major expansion of its production facilities and wants to raise
₹ 50 lacs. The finance manager of the company Mr. Prabhakar has recommended that the
company can raise funds of the same amount by issuing 7% debentures. Given that
earning per share of the company after expansion is ₹ 35 and tax rate is 30%, did Mr.
Prabhakar give a justified recommendation? Show the working.
Ans Earnings per share = ₹ 35
EPS = Earnings after tax / No. of equity shares
35= Earnings after tax / 70,000
Earning after tax = ₹ 24,50,000
Interest= 50,00,000 x7/100 = ₹ 3,50,0000
Let the Earnings before tax (EBT) be x
EBT- Tax= EAT
X-0.30 x= 24,50,000
0.70 x = 24,50,000
x= 24,50,000/0.70
x= 35,00,000; Earnings before tax = ₹ 35,00,000
EBIT = Earnings before tax + Interest = 35,00,000 + 3,50,000 = ₹ 38,50,000
ROI= EBIT/ Total Investment × 100= 38,50,000 / 1,20,00,000 × 100 = 32.08%
As ROI (32.08%) is greater than the Rate of interest (7%), the company can choose to use
trading on equity to increase its EPS. The finance manager Mr. Prabhakar was justified in
making this recommendation.

3. There are two companies X Ltd and Y Ltd. Amount of total funds invested is Rs.80 lakh
each. The ratio of equity to total capital in X Ltd is Rs. 20 lakh and debts are Rs. 60 lakhs
while in Y Ltd., the total capital is Rs. 80 lakhs, sourced through equity shares only.
EBIT is Rs. 16 lakh, the interest rate on debt is @ 10% and the tax rate is 50%. Which
company enjoys favourable financial leverage and why?
Ans
 X Ltd. Y Ltd.
Earning before interest & 16,00,000 16,00,000
tax
(-) interest 6,00,000 -
Earning before tax 10,00,000 16,00,000
(-) tax @ 50% 5,00,000 8,00,000
Earning after tax 5,00,000 8,00,000
No of shares 2,00,000 8,00,000
EPS (EAT/ No of shares) ₹ 2.5 per share ₹ 1 per share

X Ltd. is in the position of favourable financial leverage as use of debt has increased the
EPS and thus, the situation is considered as favourable for trading on equity, ROI being
the same for both the companies.
4. Vivo Ltd. is a company manufacturing textiles. It has a share capital of Rs. 60 lakhs. The
earnings per share in the previous year was Rs. 0.50. For diversification, the company
requires an additional capital of Rs. 40 lakhs. The company raised funds by issuing 10%
debentures for the same. During the current year, the company earned a profit of Rs. 8
lakhs on the capital employed. It paid tax @ 40%. State whether the shareholders gained
a lost, in respect of earning per share on diversification. Show your calculations clearly.
Also, state any three factors that favour the issue of debentures by the company as part of
its capital structure.

5. Well-being Ltd. is a company engaged in production of organic foods. Presently, it sells

its products through indirect channels of distribution. But, considering the sudden surge
in the demand for organic products, the company is now inclined to start its online portal
for direct marketing. The financial managers of the company are planning to use debt in
order to take advantage of trading on equity. In order to finance its expansion plans, it is
planning to raise a debt capital of Rs. 40 lakhs through a loan @ 10% from an industrial
bank. The present capital base of the company comprises of Rs. 9 lakh equity shares of
Rs. 10 each. The rate of tax is 30%. Answer the following questions:
What are the two conditions necessary for taking advantage of trading on equity?
Assuming the expected rate of return on investment to be same as it was for the current
year i.e.,15%, do you think the financial managers will be able to meet their goal. Show
your workings clearly.

6. A company Supreme Ltd. has total capital employed of ₹ 30,00,000. Tax rate is 30% and
rate of interest on debt is 10% p.a. Earning before interest and tax is ₹ 2,50,000.
You are required to analyse the financial leverage as per the following three situations
and answer the questions:
Situation I- There is no debt.
Situation II- There is a debt of ₹ 10,00,000.
Situation III- There is a debt of ₹ 20,00,000.
(a) Advise the company regarding trading on equity. Show your workings.
 (b) State the meaning of trading on equity and financial leverage.
7. A company has EPS of ₹ 1.80 per share. It has total share capital of ₹ 10,00,000 divided
into shares of ₹ 10 each. It has borrowed ₹ 20,00,000 as loan from bank at the rate of
10% p.a. Tax rate is 40%.
Is the decision to include debt in the capital structure of the company is justified? Show
your working.
Ans Earnings per share = ₹ 1.80
EPS = Earnings after tax / No. of equity shares
1.80= Earnings after tax / 1,00,000
Earnings after tax = ₹ 1,80,000
Interest= 20,00,000 x 10/100 = ₹ 2,00,000
Let the Earnings before tax (EBT) = x
EBT- Tax= EAT
x-0.40 x= 1,80,000
0.60 x = 1,80,000
x= 1,80,000/ 0.60
x= 3,00,000; Earning before tax = ₹ 3,00,000
EBIT = Earning before tax + Interest = 3,00,000 + 2,00,000 = ₹ 5,00,000
ROI= EBIT/ Total Investment × 100= 5,00,000 / 30,00,000 × 100 = 16.67 %
As ROI (16.67%%) is greater than the Rate of interest (10 %), the decision to use debt in
the capital structure is justified. It is a situation of favourable financial leverage which
enables trading on equity.